In spite of claims you may have seen on some FOREX web sites, FOREX is never risk-free.

Risks

In spite of the claims you may have seen on some FOREX web sites, FOREX trading is
never completely risk-free.

After all, you are trading with substantial sums of money in a market with several factors at play, and
there will always be a possibility that trades will go against you.
There are, however, trading tools that can minimize the risk of trading FOREX. With
caution and knowledge, the FOREX trader can learn to trade profitably
while minimizing losses.

Scams In FOREX Trading

FOREX scams were fairly common a few years ago. The industry has
cleaned up its act considerably since then, but you still need to
exercise caution when signing with a FOREX broker. Do some background
checking. Reputable FOREX brokers will be associated with large
financial institutions such as banks or insurance companies and they
will be registered with the proper government agencies. In the United
States brokers should be registered with the Commodities Futures
Trading Commission (CFTC) or a member of the National Futures
Association (NFA). You can also check the local Consumer Protection
Bureau and the Better Business Bureau.

Risks in
FOREX Trading

Assuming you are dealing with a reputable broker, there are still risks
to FOREX trading. Transactions are subject to unexpected rate changes,
volatile markets and political events.

Exchange
Rate Risk –
refers to the fluctuations in currency prices over a trading period.
Prices can fall rapidly resulting in substantial losses unless stop
loss orders are used when trading FOREX. Stop loss orders specify that
the open position should be closed if currency prices pass a
predetermined level. Stop loss orders can be used in conjunction with
limit orders to automate FOREX trading – limit orders specify
an open position should be closed at a specified profit target.

Interest
Rate Risk – can
result from discrepancies between the interest rates in the two
countries represented by the currency pair in a FOREX quote. This
discrepancy can result in variations from the expected profit or loss
of a particular FOREX transaction.

Credit
Risk – is the
possibility that one party in a FOREX transaction may not honor their
debt when the deal is closed. This may happen when a bank or financial
institution declares insolvency. Credit risk is minimized by dealing on
regulated exchanges which require members to be monitored for credit
worthiness.

Country
Risk – is
associated with governments that may become involved in foreign
exchange markets by limiting the flow of currency. There is more
country risk associated with 'exotic' currencies than with major
currencies that allow the free trading of their currency.

Limiting Risk

FOREX trading can be risky, but there are ways to limit risk and
financial exposure. Every FOREX trader should have a trading strategy
– knowing when to enter and exit the market and what kind of
movements to expect. Developing strategies requires education - the key
to limiting FOREX risk. At all times follow the basic rule: Do not
place money in the FOREX that you cannot afford to lose.

Every FOREX
trader needs to know at least the basics about technical
analysis and how to read
financial charts. He should study chart movements and indicators and
understand how charts are interpreted. There is a vast amount of
information on FOREX trading available both on the Internet and in
print. If you want to be successful at FOREX, know what you are doing.

Even the most
knowledgeable traders, however, can't predict with absolute certainty
how the market will behave. For this reason, every FOREX transaction
should take advantage of available tools designed to minimize loss.
Stop-loss orders are the most common ways of minimizing risk when
placing an entry order. A stop-loss order contains instructions to exit
your position if the currency price reaches a certain point. If you
take a long position (expecting the price to rise) you would place a
stop loss order below current market price. If you take a short
position (expecting the price to fall) you would place a stop loss
order above current market price.

As an
example, if you take a short position on USD/CDN it means you expect
the US dollar to fall against the Canadian dollar. The quote is USD/CDN
1.2138/43 - you can sell US$1 for 1.2138 CDN dollars or sell 1.2143 CDN
dollars for US$1.

You are selling US$100,000 and buying CDN$121,380. Your stop loss order
will be executed if the dollar goes above 1.2148, in which case you
will lose $100.

However,
USD/CDN falls to 1.2118/23. You can now sell $1 US for 1.2118 CDN or
sell 1.2123 CDN for $1 US.

Because you
entered the transaction by selling US dollars (buying short), you must
now buy back US dollars and sell CDN dollars to realize your profit.

You buy back
US$100,000 at the current USD/CDN rate of 1.2123 for a cost of 121,223
CDN. Since you originally sold them for CDN$121,380 you made a profit
of $157 Canadian dollars or US$129.51 (157 divided by the current
exchange rate of 1.2123).